Panning for Gold

The Wise Men of Wall Street tell us all the time that investing in stocks is "risky." Of course, it's not so risky that they don't want us to do it; they just would rather we not do it ourselves. Instead, we're to quietly hand over our money and leave the stock-picking to the professionals.

The problem is, when you hire professionals, you pay through the nose -- generally about 1% to 2% of your entire investment. Got $10,000 to invest? Then a $200 fee may not seem unreasonable. But when you're investing something closer to $100,000, that 1%-2% is going to hurt. And if -- like most money managers -- your advisor underperforms the S&P 500, that's just adding insult to financial injury. If you're a small investor working to build a nest egg for your retirement or your kids' college fund, wouldn't you rather beat the market handily and pocket that 1%-2% annual commission rather than give it to some banker?

We sure would. And we have. At the Fool's flagship investing newsletter, Motley Fool Stock Advisor, we've managed to guide our members to 64% returns since April 2002. Compare that to the S&P 500's 20% return over the same period.

What's more, we encourage our members to research stock ideas themselves -- and to that end, every month we reveal a new lesson on how to find winning stocks so that when you go prospecting on your own, you'll have the tools you need to succeed.

In that spirit, today I offer up my own personal favorite. I call it "The Seven Steps." While it's not a surefire tool for picking winners, I've found that these steps do provide a basic, if not exhaustive, picture of how a business is doing. Best of all, the whole process takes only about five minutes.

The seven steps
The first step in analyzing any company is to identify its ticker. Luckily, the Fool makes this easy. Click here, type in the name of the company you're interested in, and voila! A list of likely matches will pop up. Just click through them until you find the one you seek. For today's example, we'll put toymaker Hasbro (NYSE:HAS) to the test.

Yes, I'm cheating. Hasbro is already a Stock Advisor pick, so we already know it's a good company. But the real reason I'm using it is because its unique name makes it easy to identify its ticker. So go ahead. Click the link, type in the name, and you'll see that Hasbro's ticker is HAS.

Next, click on the ticker, and you'll see a bit of basic information on the company -- recent Fool articles mentioning Hasbro, press releases, and postings from our Hasbro discussion board. In the left-hand column, you'll also find links to our partner site, Yahoo! Finance. Click the one titled "Key Stats," and let's start crunching some basic numbers:

• Enterprise value
• Free cash flow
• EV/FCF
• Projected earnings growth
• Return on equity
• EV/FCF/G
• Insider ownership

Enterprise value
The first entry in the center column tells you the size of the company. Hasbro's market capitalization is "3.66B," or $3.66 billion. This number may vary, depending on when you check.

To determine Hasbro's enterprise value (EV) -- the value of the business independent of its cash and debt -- subtract from the market cap its cash and equivalents and add its long-term debt. Or just look at the second line of the center column, which tells you the EV is $3.71 billion.

Free cash flow
Next up: free cash flow (cash from operations minus capital expenditures). Click through to the "Cash Flow" link below the center column. Add up the last four quarterly entries for "Total Cash Flow From Operating Activities," and then subtract from those the entries for "Capital Expenditures." The result is the company's free cash flow (FCF) over the past four quarters, $378.1 million.

EV/FCF
Now divide the enterprise value by the free cash flow, and you've got your first important metric: EV/FCF = 9.8. The EV/FCF tells you how many years it will take for Hasbro to repay you your entire investment if it continues to rake in greenbacks at the same rate it is doing now.

In a perfect world (meaning a recession, when almost all businesses are priced to sell), I prefer to invest in companies that sell for an EV/FCF of less than 10. This is not a hard-and-fast rule -- sometimes, you'll do quite well buying a fast-growing company at an EV/FCF of as high as 20. But be warned: The higher the EV/FCF, the greater the risk.

Projected earnings growth
Look at the left column of the page and click on "Analyst Estimates," the second hyperlink under the bolded "Analyst Coverage" heading. Scroll to the bottom of the page, where you see a table titled "Growth Est" in bold. In the first column of that table, you will see an entry titled "Next 5 Years (per annum)." The column to the right of it shows that over the next five years, the analysts following Hasbro CNS expect it to increase its earnings 10% per year.

EV/FCF/G
We've already determined that Hasbro's EV/FCF is 9.8. That's its current "valuation," and suggests that the company is attractively priced even if its business never grows at all. The thing about companies, though, is that the good ones do grow. Over time, they get bigger and better at making more and more money for you.

The metric for valuing that growth potential is the EV/FCF, divided by the company's estimated growth: EV/FCF/G. Ideally, we want to find companies that sell for an EV/FCF that's lower than their G (growth rate), yielding EV/FCF/G of less than 1.0.

In Hasbro's case, the formula works as follows: 9.8/10 = 0.98. That'll do just fine.

Return on equity
Sometimes, analysts make mistakes. They get overly optimistic about a company's prospects and predict unrealistic levels of growth. So, to "quality check" their projected earnings, I like to confirm that the expected growth isn't too far ahead of the company's recent experience in generating profits. To do this, go back to the "Key Stats" page and look at the center column, third bolded category ("Management Effectiveness"), second line under the category "Return on Equity" (ROE). You want that number to be equal to or greater than projected earnings growth.

For Hasbro, the ROE of 12.59% exceeds the projected growth rate of 10%. Which is wonderful -- far from showing that analysts are overoptimistic, it looks like they may be overly conservative. Hasbro could be an even better bargain than we initially thought, especially when compared with its competitors:

From the above, only JAKKS Pacific appears more obviously undervalued than Hasbro. (Although, upon closer examination, you may find that JAKKS isn't quite as cheap as it appears on the surface.) Marvel, too, looks like a contender based on its high ROE -- but then that's not surprising: Marvel, too, is a Stock Advisor recommendation.

Insider ownership
After going through all of the above steps, and determining that a company is attractively priced, there's one more fact to check: Do insiders have a significant stake in the business's success?

Look at the far right column, second bolded category ("Share Statistics"), fifth entry. The "% Held by Insiders" category, or percentage of all shares outstanding that company officers and large shareholders own, is 9.76%.

Ideally, I try to invest in companies where insider ownership lies somewhere in the 10%-20% range. When insiders own such a significant portion of the business, their motivations align very well with those of the small shareholders: The better the company and its stock does in the long term, the better for their (and our) wealth.

On this last step, be aware that the larger the company, the harder it is for insiders to amass a large stake in its stock. There's a big difference between the cash it takes to own 10% of a $10 million company and that of a $10 billion company. So when Hasbro misses the magic 10% cutoff by the skin of its teeth, I'm more than willing to cut the company a bit of slack.

A word to the Foolish
The seven steps give you a basic overview of a company and its valuation, with an emphasis on "basic." Before investing your hard-earned cash, it's best to do further due diligence, double-check that the numbers you see on Yahoo! are the same ones shown in the company's SEC filings, and talk over your idea with other investors who may already know your prospective investment.

One fine place to do this is on the Stock AdvisorStocks That Interest You board. If you're a Stock Advisor subscriber, just click that link above and start talking. If you're not yet a member, we're offering a 30-day free trial so you can give the service a test drive. It's the perfect time to do so -- Tom Gardner reviews all of his past picks in the current issue, and David Gardner will do the same for his active selections in the upcoming edition. You'll also have access to our archive of issues and all our discussion boards. Just click here!

This article was originally published on Dec. 29, 2004. It has been updated.

Fool contributorRich Smithowns shares of Marvel. Mattel is an Inside Value pick. The Motley Fool is investors writingfor investors.